Monetary Policy: Reforms hold the key

Contrary to the market expectations of status quo, the Reserve Bank of India hiked repo rate by 0.25% in its third quarter review of monetary policy for FY14. The repo rate now stands at 8%. The Cash Reserve Ratio (share of deposits banks have to park with the RBI) was however kept unchanged at 4%. The central bank has been addressing inflation risks while recognizing weak economic growth.

Economic scenario

Economic growth and unemployment scenario continues to remain grim in the US and Eurozone. Moreover uncertainties with respect to prospects of emerging economies remain. Back home, the GDP growth rate has not witnessed any significant uptick. The growth in the manufacturing sector has slowed while the agricultural growth stands worrisome. The central bank has cut the growth forecast to less than 5% for 2013-14. That said the RBI Governor remains sanguine of the turnaround in broader economy in the next financial year.

The wholesale price index (WPI) and the consumer price index (CPI) at 6.2% and 9.8% respectively still stand above the desirable levels. Despite good monsoons and bumper crop, the CPI continues to be in double digits. With rise in wages, the services inflation has been driving the core inflation higher. The increased policy rates are expected to tame the consumer price index.

The gravest risk to the value of the rupee is also from CPI inflation. Moreover, elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This, in turn, discourages investment and weakens growth.

Policy stance

Given the lower inflation rates in December 2013, the rate hike move was unexpected. The beleaguered corporate India which has been clamoring for interest rate cut, will have to brace for higher funding costs. The prevalent higher borrowing costs and the high raw material costs have already strained corporate profitability.

Inflation seems to be on a downward trajectory, but credit growth and GDP is seeing a slowdown. The credit growth for the banking system has been struggling in the range of 14%-15% for quite some time now. Marred by economic slowdown and stalled infrastructure projects, credit growth is expected to remain subdued in the near-term.

The way forward....

The RBI does not see near-term rate hikes if inflationary conditions were to improve from the current levels. Also, the central bank has maintained that rate cuts are not the only solution to curbing inflation and stimulating growth.

The RBI's insistence of policy reform support from the government to balance growth and inflation has so far yielded no results. Going forward too we expect the face-off between the government and the RBI on monetary policy stance to continue.